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The US dollar is rallying and you own a bond or a bond ETF. Quick – what effect will this rally have on your bond’s payouts?

If you are unsure, you are not alone. It’s a question we have been fielding recently light of the US dollar’s rally relative to other currencies, and the answer depends on the type of bond or bond ETF you hold.

To figure out the impact of currency movements, you first need to know what currency your bond is denominated in. (Note: Since most of the questions we’ve been getting come from US investors, my comments reflect the perspective of an investor whose home currency is the US dollar.)

If a bond is denominated in US dollars then the answer to this question is very simple: Exchange rate movements have no impact on the price of the bond.

Take US Treasury bonds as an example. A holder of a US Treasury (and a Treasury ETF) is holding debt that will be repaid in US dollars. A change in the exchange rate of the US dollar in relation to other currencies will not impact the US dollar value of the cash flows the bond pays. This is true even of bonds that are issued by foreign issuers and denominated in US dollars.

But as I mentioned in my Clearing up Corporate vs Credit blog, the US bond market contains many securities from issuers outside of the United States. For example, iShares offers an emerging market bond fund (NYSEARCA:EMB) that holds USD-denominated bonds that were issued by emerging market governments. Movements in the value of the US dollar will not have an impact on the total return of the underlying bonds or the ETF because all of the bond cash flows are in US dollars.

Now let’s say you own a security that is denominated in a currency other than the US dollar. In this case, exchange rate movements can have an impact on the bond’s total return. Consider a US investor holding a bond issued by the British government that is denominated in British pounds.

If the pound depreciates relative to the US dollar then the pound cash flows paid by the bond will be worth fewer US dollars. Currency depreciation decreases the total return on the bond, just as currency appreciation would increase returns. An ETF that held the British government bond would be impacted in the same way.

Looking at this issue more broadly, currency risk is one of the primary risk factors of fixed income securities. The table below displays the major risks for bonds from a range of sectors. (For a complete list of risks, please refer to the fund’s prospectus.)

Risk Exposure in Bond Market Sectors

Bond Market Sector iShares Tickers Interest Rates Inflation Credit Risk Currency
US Treasuries SHV,
SHY,
IEI,
IEF,
TLH,
TLT
X X
US TIPS STIP,
TIP
X
International Inflation-Linked bonds GTIP,
ITIP
X X X
International Treasuries IGOV,
ISHG
X X X X
EM Debt (USD) EMB X X X
EM Debt (Local) LEMB X X X X

Interest rate risk represents the exposure a bond has to changes in interest rate movements — all fixed income securities are exposed to interest rate risk.

Inflation risk impacts the majority of bond segments, except for inflation-linked bonds that help insulate against inflation risk as their principal adjusts with changes in inflation. Credit risk refers to the risk that a bond issuer will default – this is a risk for all issuers outside of the US Treasury (and a case could be made that credit risk resides there as well).

Currency risk is the risk coming from holding bonds in a currency other than USD as discussed above, this is the case for local currency developed and emerging market securities.

Note that within emerging markets (EM), there are bonds denominated in US dollars and bonds in local currencies. Initially EM bond issuers came to the US bond market to issue debt since their local markets were just developing. Now they also offer debt in the local currencies that are available to foreign investors.

Using ETFs, an investor can decide which risks they feel comfortable taking. They can also use ETFs to express views on interest rates, inflation, credit risk and even foreign currencies. In a future post I will talk more about the differences between USD and local EM debt.

Disclaimer: In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume.

Bonds and bond funds will decrease in value as interest rates rise. TIPS can provide investors a hedge against inflation, as the inflation adjustment feature helps preserve the purchasing power of the investment. Because of this inflation adjustment feature, inflation protected bonds typically have lower yields than conventional fixed rate bonds and will likely decline in price during periods of deflation, which could result in losses. Government backing applies only to government issued securities, not iShares exchange traded funds. An investment in the Fund(s) is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency.

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Source: Bonds, ETFs And The Currency Connection